Can Instinet find a more profitable course after a sweeping corporate divorce?
The marriage wasn't bad, but Instinet is hoping the divorce will be even better.
Instinet – a big industry player hard hit by a brutal two-year pricing war in its ECN business – is separating the ECN from its more profitable institutional brokerage operations. The brokerage will seek buyside order flow while the ECN, now known as INET, will pursue sellside orders.
The split seems like good news for the brokerage, a business which contributes about 70 percent of Instinet's revenues. But it could spell trouble for the ECN. It means the ECN loses access to a guaranteed source
of order flow. The institutional brokerage, on the other hand, is free to grow its business, uncompromised by any real or imagined conflict of interest that comes from its ties to a proprietary liquidity pool.
"We have clearly separated the two," Instinet chief executive, Ed Nicoll, told Traders Magazine in an interview. "I want our buyside customers to know Instinet is the one place they can go to that they can absolutely trust will do the right thing by them."
Special Advantage
The break is along legal, financial, geographic, technological, and staffing lines. It forces both groups to compete solely on the merits of their own business models. Any special advantage one group had because of its relationship with the other is now gone.
Nicoll, who says he is devoting most of his energies to the agency brokerage, has no qualms about cutting the ECN loose. "We're not in the business of trying to preserve our liquidity pool at the expense of our customers," Nicoll said. "We're in the business of trying to utilize that liquidity pool when appropriate. We are prepared to be 100 percent neutral."
Perhaps with his shareholders in mind, he added: "The other element is that we make very little money on that liquidity pool. It's a very low-margin scale business. It would never make sense for us to risk our agency brokerage business to give an order to INET."
In the coming years, the brokerage business is expected to outshine the ECN. Sandler O'Neill & Partners analyst, Richard Repetto, notes that Instinet's "long-term meaningful profitability is driven by the VAB's ability to increase penetration rather than increased liquidity on the ATS, INET." (VAB stands for "value-added brokerage," Instinet's internal designation for the unit.)
Repetto's research shows that, for every one percent uptick in market share, the brokerage adds 10 cents to 12 cents to its annual earnings per share. The ECN adds only one or two cents.
Repetto's conclusions are shared by some on the buyside. They expect Instinet to raise its prices for its services requiring a "sales trader," the new designation for what used to be termed facilitator or account rep. Instinet, though, denies it plans to raise prices.
The unraveling is the latest in a series of restructurings at Instinet over the past two years. The firm has been jettisoning employees, technology and businesses in response to almost overwhelming competition on both of its business fronts. From 2,132 employees at the end of 2001, Instinet has shed 873, leaving it with 1,259 at the end of last year's third quarter. More employees will see pink slips this year, according to Nicoll.
Instinet has seen its revenues slump to $1 billion annually for each of the past two years. That's down 25 percent from the peak year of 2001. And that's despite a steady increase in the number of shares processed -139 billion last year (annualized from the first 11 months); 97 billion in 2002; and 77 billion in 2001. Instinet has had to repeatedly cut its prices to stay in the game.
The maneuvering on price has hurt both sides of the business, but it is the ECN that has most suffered. For its broker dealer customers, the ECN has drastically lowered the price to take liquidity off the book, and increased sharply its rebates for providing liquidity.
Two years ago, the gap between the per-share charge to the buyside and the net take from the sellside was considerably less. Now, on average, the sellside pays 2/10ths of a cent per share to trade while the buyside pays about 1.5 cents. At one time, some sellside traders could also expect to pay about 1.5 cents.
This radical change in the pricing differential has clearly served to delineate two completely different businesses: a low-cost marketplace for broker dealer executions and a high-tech institutional brokerage. Any mystery over where the brokerage begins and the ECN ends has dissipated in the stark reality of today's more competitive environment.
Order Book
And by and large, it has been difficult to discern a bona fide agency brokerage within Instinet. That's because most of its buyside customers use Instinet in the same way as its sellside customers. They post bids and offers, and trade against others' bids and offers – anonymously – on a publicly accessible order book. That means, of course, that the identity of each party is not publicly shown.
Three-quarters of Instinet's buyside customers are do-it-yourselfers. That is, they need little assistance from Instinet to complete trades. Traditional agency brokerages, on the other hand, employ sales traders to work customer orders.
It was not until 1990, 21 years after its founding, that Instinet even started calling itself an agency brokerage. The firm, originally the Institutional Networks Corp., started in 1969 as an order matching system for the buyside. It was dubbed the "Fourth Market," a quasi-stock exchange. But it wasn't very successful.
Volume limped along until the late 1980s. That's when then chief executive, Bill Lupien, opened the system up to Nasdaq market makers. The traders made Instinet their own and liquidity improved.
Then came the technology boom of the '90s and Nasdaq stocks got too big for institutions to ignore. The more sophisticated among them started to use Instinet as a means to trade large blocks. Nowadays, about one quarter of all volume traded on INET is sourced directly from the buyside.
Despite the increased institutional presence, it has only been in the past few years that Instinet has taken any steps to physically separate its front-end brokerage services from its back-end processing. Instinet didn't even begin to acknowledge it had sales traders until recently.
Given the hefty pricing disparity between buyside and sellside customer orders, the decision to split the company is perhaps inevitable. That's because the split frees the more profitable agency brokerage from the confines of its relationship with the struggling ECN. Certainly, the agency brokerage has the most to gain while the ECN has the most to lose.
INET loses a near lock on the approximately 90 million shares per day handled by the institutional brokerage. The brokerage, on the other hand, by severing its tie to INET, loses less than it would have a few years ago. Nowadays, any broker, alternative trading system or front-end vendor can access INET's full depth of book. Until recently, only Instinet customers could do so.
That means it is no longer imperative for the buyside to have a relationship with Instinet in order to access INET. The value of that tie has already diminished.
The Benefit
Breaking the company in two to benefit the brokerage looks smart if there is even the possibility the ECN is holding the brokerage back. As a stand-alone entity, the brokerage does not have to try to balance the needs of INET with those of its customers. The split eliminates the real or perceived conflict of interest.
For instance, the agency brokerage used to dump all orders over which it was given trading responsibility onto the ECN. Now its sales execs can assure buyside traders that won't automatically happen.
Although that pool is one of the four biggest in the Nasdaq world, it is also populated with a lot of sharks: broker dealers looking for meat in the form of information and a fast buck. "That pool was, in some ways, a dangerous place to play," Natan Tiefenbrun, co-president of the institutional brokerage, told Traders Magazine.
Some have speculated that Nicoll is positioning the ECN for a spin-off. Nasdaq is usually mentioned as a possible buyer. Is that the case? "No," Nicoll said simply. That the question gets asked reflects the difficult operating environment of electronic execution venues. Besides INET, there are three other significant players – SuperMontage, ArcaEx and Brut. All have been bloodied by price wars in the past two years. Yet, all are hunkering down for a fight to the finish.
The Migration
INET is the result of the "merger" of the Instinet ECN with the Island ECN, purchased by Instinet in 2001. As Traders Magazine went to press, all orders on the Instinet ECN were being migrated to the Island ECN. The company chose the Island platform because it is newer and dedicated to order matching. The much older Instinet platform is more complex and sprawling, according to INET President Alex Goor.
Cost is everything in the ECN world. So, to save on rent, the INET group is moving to New Jersey. The team of 75 employees is moving out of Instinet's modern Times Square office building, with its stone-and-glass curtainwall exterior directly across from Nasdaq, to Jersey City.
Goor is upbeat about INET's prospects despite the dissolution of the relationship with the brokerage side. "There are risks in disentangling ourselves from one of our major customers," Goor told Traders Magazine. "Certainly, their liquidity is more portable. But our hope is that they will continue to choose us as a destination based on our own merits."
Goor also hopes that the creation of INET, one of the Nasdaq market's three largest public order books, will generate its own momentum. "One big liquidity pool will hopefully attract more liquidity than two smaller ones," Goor said.
The exec isn't sitting back waiting to see what happens though. Instinet introduced new outbound routing pricing last fall in a bid to thwart the power of that great ECN equalizer: the front-end trading system. The hope is that more orders will hit INET even if there appears to be little chance they will execute there. [See sidebar.]
Trading front ends, such as those licensed by Lava Trading and Sonic Financial, have helped to commoditize ECNs (and SuperMontage) by aggregating all books on one screen. Traders can more easily access the best price while only dealing with one screen rather than several.
Still, INET's independence is not guaranteed. Between the fourth quarter of 2002, right after Island joined Instinet, through the third quarter of 2003, the combined Nasdaq market share of the two books has steadily declined. The number of Nasdaq shares traded on both books as a percentage of all Nasdaq shares traded, dropped from 27.4 percent in the last three months of 2002, to 22.5 percent in the third quarter of 2003.
So what happened? Goor suggests four possibilities: lower prices by competitors; INET's use of sub-penny pricing, an irritant to some traders who may have moved elsewhere; program traders that have moved elsewhere (Brut has made inroads here); and an increase in Nasdaq market makers internalized trades due to a resurgence of the retail sector. That would cause both the denominator and market makers' share of that pie to rise.
All is not gloom and doom in the ECN world. Sometime this year, the Securities and Exchange Commission is expected to decide on the future of the Intermarket Trading System's trade through rule. The rule prevents traders from executing certain trades in securities listed on the New York Stock Exchange anywhere but on the Big Board itself. The SEC may water down or eliminate the rule. That could lead to a significant migration of order flow away from the New York Stock Exchange, observers predict.
INET would undoubtedly benefit from a rule change. Those traders seeking executions faster than those available on the New York would likely shift their business to electronic venues. Nicoll has been one of the most vocal proponents for the repeal of the ITS trade through rule. Last fall, for instance, the exec broached the subject in his testimony before the House Financial Services Committee's market structure hearings.
But, in pounding the table for his cause, Instinet's CEO is not just championing INET. Instinet, the institutional brokerage, could garner more listed order flow as well. "If there are viable electronic markets to probe and utilize in the listed environment," Nicoll said, "we will get much narrower spreads. We will be able to do more blocks upstairs and away from the floor."
The trading of listed shares is not an insignificant issue for Instinet. Most large brokerages catering to institutions, and practically all agency brokerages, handle more listed than Nasdaq order flow. That's because the buyside trades more listed than Nasdaq names. Perhaps three-quarters of the orders on a typical large buyside desk are for listed shares.
Instinet is best known as a Nasdaq shop. Most of the 90 million shares per day handled by the brokerage side are in Nasdaq names. Nicoll says a "significant" portion of those 90 million shares is listed flow, but will not specify exactly how much.
The exec does say he does not consider 20 percent to be a "significant" number though, suggesting Instinet is trading more than 18 million listed shares per day.
At the same time, the broker is taking steps to lift its profile in the listed world. A year ago, Instinet exercised an option to pay about $600,000 for ownership of a New York independent floor broker called Harborview. (Instinet acquired about 10 percent of Harborview when it bought agency broker Lynch Jones & Ryan in 2000.) It also bought an additional seat at the New York Stock Exchange, giving it a total of four seats.
A New Crew
After acquiring Harborview, Instinet fired the entire staff and installed a new crew of traders. "We completely turned over all the personnel because we didn't believe they were of the quality to serve our customers," Nicoll said. The Harborview staff is working strictly with Instinet's sales traders, but may eventually do double duty as a direct access broker for Instinet's customers.
Instinet has made similar adjustments to its sales trading staff, firing some and hiring others. "Some of our sales traders grew up in an environment in which Instinet was the only liquidity pool around," Nicoll said. "They didn't necessarily have the trading expertise that is demanded of the position."
"We have upgraded that position," he added. "We have a much higher quality staff today than we had five years ago."
Some on the buyside expect to be paying more for that upgrade. "What they are saying," said one buyside trader who did not wish to be identified, "is what you got for free before, which is a sales trader, you will now pay for."
Mike Plunkett, co-president of the VAB, says Instinet is not raising prices, but has tiered them in recent months to reflect its customers' differing needs. Those who use sales traders already pay more than those who just want electronic connectivity, Plunkett explains.
Plunkett, though, says he would like to see an increase in the VAB's blended rate of 1.5 cents. "But the way to increase that is not to raise prices," the exec stressed. "It's to get more customers using the higher priced premium services and for the client to find value in our premium services."
Plunkett adds that Instinet's sales traders will be taking a more proactive role vis-a-vis customers. That means more outbound telephone calls delivering information and research.
For a long time, Instinet never even acknowledged it had sales traders. It called those pros responsible for working with the buyside "facilitators." The reason, it says, was to put its do-it-yourself customers at ease.
Sophisticated
To those sophisticated customers who need very little assistance and only want access to Instinet's technology, the phrase "sales trader" conjures up images of leaked information. Instinet has had the delicate task of pleasing both those customers who want to hide their intentions from everybody and those who needed sales trading.
"There is always a tension between those customers who want the human sales trader and those who want total anonymity," Nicoll explained. "Instinet walked a fine line. For some people we sales traded and for others we didn't. We never defined it or were clear about it."
Nicoll now says it is better to be clear about who does what. In its trading room, the facilitators sit separately from the sales traders. The firm also recently published a sales trader "Code of Conduct" manual that it sent to clients. One topic concerns protecting client information.
Instinet now has about 150 front-office staff in the U.S. It is hiring sales traders. The build up on the desk, as well as on the floor, is calculated to make Instinet a more powerful player in the handling of block orders.
But despite the need to match competitors' order handling prowess, Nicoll maintains there is a critical difference between Instinet and other institutional brokerages. "We will deliver our network of bids and offers to our customers," he said.
Instinet is introducing new technology that will emulate the actions of a human trader. That is, one who attempts to cross his customer's order with that of another customer's upstairs while simultaneously representing the order in the public market. In a departure from standard practice, though, Instinet will allow its customers to see its other customers' quotes.
"We will not intermediate between our customers when it is not necessary," Nicoll said. "Our job is to act as agent. We're happy to show one customer the other side of the trade."
Often traders will try to cross orders upstairs rather than bring them down to the floor of a stock exchange or trade them in the Nasdaq market. If successful, the cross acts to lessen market impact, or adverse price reaction, as well as provide the broker with two commissions. Usually, the trader working the order keeps his book of orders to himself though.
Instinet intends to make that book available to its customers. They would not know the orders' origin, but would see prices and size.
The technology has two parts. First is an alternative trading system dubbed CBX, for Continuous Block Crossing. CBX is a closed order book accessible by Instinet's buyside customers only. The system allows traders to view, post and automatically trade against orders. Trades are not negotiable. Listed trades will print on Nasdaq. Nasdaq trades will print on the ADF.
CBX works in tandem with a second system called Proactive SmartRouter. In contrast to standard smart routing technology that hits bids and lifts offers, Instinet's Proactive would post bids and offers.
Testing the Water
So, while most of a block is sitting in the cross, the smart routing technology is testing the waters of the public market by posting limit orders. The tasks are essentially those a trader performs. He holds the bulk of the order close to his vest while parceling out small pieces at a time.
By grafting the smart router onto the cross, Instinet is trying to respond to an age-old complaint. Buyside traders like the idea of using closed crossing systems, but they don't want to lose the ability to quickly transact in the public market if conditions warrant.
"Institutions say: I would love to be able to trade electronically,'" Tiefenbrun explained. "But I can't. Because if a print goes up on the New York, then my portfolio manager calls me and asks me why I didn't participate in that print.' They're afraid of the opportunity cost of not being present on the floor."
The new technology illustrates how Instinet is both changing and staying the same. "When you give us 250,000 shares today," Tiefenbrun explained, "we're not going to put the whole order onto an ECN. But we're still going to provide an efficient means to find the other side."
Instinet's message of "unconflicted" executions is winning praise from the analyst community. Daniel Goldberg, of Bear Stearns, notes that "the unconflicted, agency only model of Instinet's VAB bodes well in the current regulatory environment."
The model is right for the times, stresses Nicoll. While other Wall Street firms have been the target of regulators' wrath for mixing brokerage with banking and mutual fund sales, Instinet has stayed above the fray.
"We have not engaged in a single business line conflict," Nicoll said. "Except for perhaps the ownership of a liquidity pool and an agency broker at the same time."
And that marriage is over.